The browning of America

In politics, the urgent but not necessarily terribly important always trumps the important but not palpably urgent. In the US today, getting out of the economic downturn is urgent, but not a matter of life and death. Moving towards sustainable energy use and cutting back on man-made contributions to global warming is a matter of life and death, but not immediately so in the US. When there is a conflict between a speedy exit from the recession and saving the environment, the environment therefore loses.

Since the crisis hit, it has been clear that the only pro-environment policies that have a chance, in the US and possibly elsewhere too, are those that involve increased public spending. In this case environmental and Keynesian demand-boosting imperatives point in the same direction. Examples are grants for home insulation, support for R&D and environmentally friendly infrastructure expenditure such as public transport improvements. When environmental logic demands policy measures that increase costs to the private sector, however, the fact that such measures impose a financial burden on an already groaning private sector means that such measures will at best be watered down, at worst not implemented at all.

We have just seen two examples of this – the strange and deeply uninformed debate about a cap & trade scheme for CO2E emissions recently introduced in the House of Representatives, and the admission by the US Secretary of Energy, Dr. Steven Chu that bringing US fuel taxes (especially taxes on gasoline/petrol) is politically out of the question for the time being.

Reducing the emission of greenhouse gases can be done in one of two ‘pure’ ways. The same holds for reducing the consumption of energy, including energy consumed by burning gasoline to move cars around. You either use quantity rationing, that is, physical rationing of the commodity whose use you wish to discourage or you make it more expensive through taxes or other charges. This is just the translation into domestic economy language of introducing binding quotas or tariffs in international trade language.

You can also combine the quota and charging approaches. Quantity rationing of individual users is clearly a complex and administratively costly exercise, even though it has often been used in war time, when scarce commodities were rationed, with individual entitlements (vouchers) sometimes tradable, sometimes not tradable officially but traded informally or even illegally on a grey or black market. Cap & trade is an example. The policy authority sets an overall quota that is intended to be less than what would be consumed or produced without government intervention. Call the size of the Quota Q. Think of Q vouchers or permits, each of which entitles the owner to emit 1 unit of CO2E emissions. All those wishing to emit some amount K ≤ Q of CO2E need to come up with an amount K of permits.

If the quota is binding (if, should the permits be free, an amount of CO2E in excess of Q would be emitted), the question arises as to who will get the scarcity value (the rents) created by this new binding constraint.In the simplest case the authorities auction off all the permits in an efficient, competitive auction procedure. That way the state gets all the rents.

The only requirement for an allocation scheme to make sense is that it increases the marginal opportunity cost to the ultimate consumer (in the case of gasoline) or producer (in the case of greenhouse gases) – the entity that chooses the quantity actually consumed or produced. Auctioning off individual units of the rationed commodity, subject to the constraint that the total amount of units sold not exceed the aggregate quota, Q, is one possibility. This raises revenue for the government.

It is equally efficient from the point of view of limiting the emission of CO2E, for the government to give part or all of the quota away – to its friends, to the Daughters of the American Revolution, to all car-driving Americans, to the power generating industry, the owners of coal mines or aluminium smelters, to the poor and the oppressed or to anyone else. As long as the allocation does not depend on current or future energy use or fuel consumption decisions, it will achieve the desired environmental effect efficiently, if there is an efficient secondary market for the permits. Even if the permits are allocated free of charge to the worst polluters (coal-fired power plants, aluminium smelters, people barbecuing in their gardens), as long as the overall quota is binding, the vouchers will have a scarcity value or opportunity cost to the recipient – they could sell them on the secondary permit market. Political considerations driving the allocations may be unfair, corrupt and outrageous, but not necessarily inefficient from an environmental perspective, as long as they do not distort the beneficiary’s marginal opportunity cost of fuel use or green house gas emissions.

Only if the emitter knows that they will get free vouchers to cover whatever emissions they would produce if vouchers were free, would there be an efficiency problem.But the overall q uota should take care of that. If the requirement that total emissions be less than or equal to Q represents a binding constraint, it is not possible to provide all would-be emitters with permits in the amount they would require to cover the emissions they would produce when permits are free. So the key issues are (1) the size of the overall quota and (2) the enforcement of the rule what without a permit you cannot emit.

U.S. Reps. Henry Waxman, D-Calif., and Edward Markey, D-Mass., recently introduced the American Clean Energy and Security (ACES) Act of 2009, which would create a cap-&amp; trade programme requiring CO2E emissions to be reduced 17 percent below 2005 levels by 2020 and 83 percent below 2005 levels by 2050. In addition to creating a cap &amp; trade system that sets the limit (Q) each year on total CO2E emissions , the proposes a carbon allowance for utilities and power-hungry companies. That allowance is just the initial allocation of part of the overall quota or cap.

As long as the overall quota is adhered to, and as long as the secondary permits markets functions efficiently, the opportunity cost to the emitters of CO2E will come out about the same, regardless of the initial allocation of the allowances. The consumer will ultimately bear the full cost at the margin where it should be felt if the policy is to have its desired environmental effect: when consuming energy whose generation, transmission and delivery produced CO2E emissions.

It is my guess that the reality that ultimately the consumer of CO2E-intensive products will pay the price of restricting CO2E emissions, regardless of the initial assignment of the permits, will dawn on the body politic of the USA. When this happens, the overall CO2E emissions ceilings will be relaxed from the levels proposed in the ACES ACT.

What this discussion shows is how much superior a straightforward uniform tax on CO2E emissions would be to a cap &amp; trade scheme. It avoids the non-transparent initial allocation of the permits, and it does not require an efficient secondary market for permits trading. Efficient financial markets have not exactly been prominent since August 2007. Trusting the efficient allocation of permits to the same people and institutions that brought us the Great Financial Crisis of 2007-2008 would not, in my view, be wise. Taxing emissions makes exactly the same informational demands on the authorities as the cap &amp; trade scheme – they must be able to monitor the actual volume of emissions. Taxing emissions avoids the potential problems of speculative bubbles and market manipulation in the markets for permits.

Federal taxes on fuel for cars

America’s consumption and production is roughly twice as energy-intensive as that in the EU. There is a simple reason for that: energy is more expensive to the end-user in the EU than in the USA. A litre of gasoline in the UK costs around £1.00, that is $1.60. That would be $ 7.04 per US gallon (dry). The latest quote I have for a US gallon of gas is $2.47. The UK price of a gallon of gas is therefore $4.57 higher than the US price. From an environmental perspective, the UK price is still too low, but let’s pass on that one for the moment.

The brave thing to do would be for the US to put a $4.57 per gallon additional Federal tax on gas. Recognising that politicians are wimps, let’s phase this in, to soften the blow: 57 cents per gallon immediately, and a credible commitment to a $1.00 increase in the Federal gasoline tax for the next four years. After that, both the US and the UK (and the rest of the environmentally well-intentioned nations, could add an additional $0.50 per gallon each year to the fuel tax, until the last gasoline-propelled vehicle has been driven off the roads. Any undesirable aggregate demand fall-out from this cost-increasing proposal could be compensated by returning the revenue raised to the public through an income tax cut or an increase in transfer payments.

Even this wimpish proposal is way beyond the delivery capacity of the US political system. Dr. Chu has discovered very soon what so many well-intentioned academics who entered politics before him found out eventually: the power of logic and facts is no match for that of lobbyists and well-heeled pressure groups. The only thing green about the Obama administration’s policy agenda are the greenbacks of the of the vested interests opposed to any meaningful environmental policy.

Back to Berkeley for Professor Chu, after a decent interval, I would have thought – assuming there still is a university at Berkeley following the imminent bankruptcy of the once-proud state of California.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.